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Wednesday, January 2, 2013

Palo Alto Confirms The IT Security Market is Still Growing

Investors in the IT security sector had a right to approach the upcoming results of company Palo Alto Networks(NYSE: PANW)
with a certain amount of trepidation. Competitors have been downgrading
expectations and enterprise spending in technology has been weaker as
the year has gone by. However, Palo Alto delivered a solid set of
results and guidance, and despite the market response (which initially
looks to be negative) this should not reflect on the operational
performance of the company. Whether the stock is good value or not is
another question.

Palo Alto Delivers Good Results

Palo Alto’s place within the security market is as a fast growing
company that is accelerating sales growth primarily via displacing
incumbent security providers. As such, we should expect it to have lower
margins and cash flow conversion than the established players but much
faster growth. The company makes a play over its quality differentiation
allowing it to carry a pricing premium. This may well be true, but as
it matures it may well find it harder to sell on this basis. Not all
customers will be focused on quality, and its primary firewall
competitors, like Check Point Software(NASDAQ: CHKP), Juniper Networks(NYSE: JNPR) and Cisco Systems (NASDAQ: CSCO), are highly cash generative and capable of upgrading their offerings in the future.

No matter, Palo Alto is firing on all cylinders at the moment and
none can match its growth prospects. A brief summary of its results.

Q1 Revenues of $85.9 million vs. estimates of $83.8 million

Q1 EPS of 4c vs. estimates of 3c

Q2 Revenue Guidance of $90-94 million vs. estimates of $90.8 million

Q2 EPS Guidance of 4c vs. estimates of 4c

So it’s a ‘beat’ and the guidance looks pretty good relative to
market estimates. This is a key point because its rivals have been
downgrading expectations and new entrants like F5 Networks (NASDAQ: FFIV) have been aggressive about their prospects in data center security.

Moreover the commentary around the results was positive with
management claiming that 50% of its new sales were for primary firewalls
(this tends to increase the lifetime value of a client as it implies
higher recurring revenues and retention ratios). In addition, they
scored a host of major wins against Check Point (with a major telco),
Juniper and Cisco (a leading European broadcaster) and a number of US
data center security solutions from Cisco.

It wasn’t quite a Larry Ellison style alpha male conference call, but
not far from it. Although he would, no doubt, be impressed by the
hiring of F5 Networks' former global head of sales. He will no doubt
bring a plethora of enterprise and data center contacts with him, and
investors should take Palo Alto seriously when its management outlines
that F5’s data center security solutions are not really competing with
the larger part of Palo Alto’s business.

But what of the rest?

What is the Industry Saying?

Essentially Check Point had lowered guidance and analysts saw some
weakness on account of its slowing product sales growth. In reality,
this is partially due to its progress in bundling software sales within
overall sales. Check Point’s overall revenue growth is in the high
single digits but no matter, the market hates slowing product growth
because it implies slowing future software sales.

Alongside this, Cisco had earlier seen its security revenues growing
at a slower pace. In other words, the market was set up for a possible
disappointment with Palo Alto. It didn’t come.

Palo Alto is a much younger company and there are no such growth
problems here, although it did disclose some more aggressive pricing
competition in the quarter. Management also claimed to have high win
rates across all its major competitors (Juniper, Cisco and Check Point)
without being drawn on any specific strength against any particular
incumbent.

Furthermore, deferred revenues are growing faster than top line
revenues (86% vs. 50% year on year), and free cash flow is now at over
20% of revenues.

Where Next for Palo Alto?

In conclusion, this is a pretty good set of results from Palo Alto.
The market’s immediate reaction is probably more about investors who
were lined up to try to take advantage of a market pop and then sell
out. It’s the sort of thing that happens with highly rated stocks.

From my perspective as a growth at reasonable price (GARP) investor, I
am not interested in Palo Alto; but I am interested in the IT security
center and this reads like pretty good news to me. Palo Alto is
affirming that conditions remain good, and I think the sector is well
worth looking at now.